Guest Post: Dollar Got Me Down: A Down Dollar Roadmap

All the talk about a dollar currency crisis is getting ahead of itself. Quoting Mises won’t make it happen overnight. It takes years, even decades for a reserve currency to dissipate. Instead of wholesale collapse, the most likely outcome is a steady decline in the dollar over an extended period of time. Of course there is a tail possibility of a collapse, and that is why hedges exist. But the high likelihood trend is persistent policy action to drive the dollar lower with respect the United States trading partners’ currencies, combined with a decline in the dollar’s use as a vehicle currency. This means serious dollar weakness for the next three years (or more), but not collapse.

The Case for No Collapse

A currency collapse isn’t an issue of preferences or sore feelings about getting screwed by any given printing press. As long as there is minimal rule of law there will be contracts legally required to settle in a given currency. This is the interlocking stability of debtors and creditors that inflation will impact by diminished term risk, but as long as contracts remain, the dollar is going nowhere. The currency is bound tightly to political order, which is more stable than anywhere else in the world.

Second, there is a network of liquidity providing and withdrawing institutions made up of central banks. If a currency makes a multi-sigma move and the central bank that issues the currency can’t handle the strain itself, other central banks can act in concert to assist. Note the massive central bank currency swap action that stopped the herd of Mrs. Watanabe’s from skyrocketing the yen back in March. This can just as easily be accomplished for the dollar or the euro or the dong.

Further, the dollar holds a privileged place as it is more than a mere national construction. Like it or not, the dollar is still viewed as more desirable than many emerging market currencies. The dollar holds a special place in the world. It is the reserve currency, meaning it is a standard of valuation for international commerce. More than this it is the vehicle currency for much of the world’s debt. This international interlocking network of debtors and creditors makes the dollar even less capable of “collapse” than the good old boy central bankers club.So you have a clear signal that the dollar is going to slide into the gutter for the next few years thanks to the Fed. This dollar weakness will become self-reinforcing when international debtors and creditors decide to ditch it as the vehicle currency. Technology and preference to not be screwed will make this happen. At the same time, there will be bouts of major volatility in the dollar as the interlocking network of debtors scramble to pay off their creditors from time to time. This volatility will diminish as the dollar’s role diminishes. There are ways to take advantage of these trends.

Some Right Tail Exposures

CME All the vol talk to CME, of recent “poison the silver spikenard” and “clearing evil CDS” ill fame. CMS has a much more lucrative money-maker than these doo-dads that have potential as a great way to exploit the end of the dollar as a vehicle currency. This is because their currency settlement technology is catching up to the realities of a world that doesn’t want dollars. CME makes it possible to not use the dollar as a trade vehicle so much. Here’s a clue to the future: CME launched a postexecution clearing service for nondeliverable forwards on the U.S. dollar versus the Chilean peso, marking the first step in offering clearing services for over-the-counter foreign-exchange transactions. Imagine that a transaction can be marked in a currency and then a nanosecond later it is converted into another currency. This is going from high latency to low latency in touching the stinky dollar. In effect, technology makes getting out of the dollar easier than ever, because conceivably CME can hold a “settlement account” for anybody in any currency. CME is placed to live off the skim.

TIF A weak dollar is easier on the rich than it is on the poor. Because of costs of entry, people with low incomes are forced to store their wealth in dollars, so they will be mercilessly screwed by the Fed and the politicians. This screwing of the dollar makes exports cheaper, hopefully creating jobs for younger people. These young people really need the jobs, because they bear the brunt of funding all the welfare, transfer payments, retirement benefits, paying the medical bills for people that have smoked for the last forty years, bailing out mismanaged union pensions, contributing to bank executive bonuses, funding congressional pay raises, and buying school supplies and aerosolized mace for their kids. They also need a therapist on retainer.

However, the wealthy take much less of a hit because their wealth is more allocated into real assets. Because they are wealthy, they spend their money on high-end goods. Further, as the dollar continues its decline and inflation pressures pick up, there will be persistent over-blown fears of hyperinflation that will drive even more wealth into real assets. A part of this will end up as shopping sprees for the better halves. In a word: Tiffany’s.

SINGY The growing rich versus poor divide combined with a steady dollar decline will help airlines because there will be plenty of people flying out this country for better opportunities and societies that respect capital. Southwest is the most financial stable of the airlines, and there will be plenty of people filling their seats as they fly out of here. Further, when the Gramma and Grandpa want to visit their almond-eyed grandkids, it will increasingly require a flight to the Orient and not a road-trip.

WYNN As the dollar continues its unrelenting decline, people will be more willing to throw their lot in with gambling what dollars for a random payoff based on well-defined probabilities as opposed to rigged financial market payoffs. Further, as emerging world incomes move up as the dollar moves down, gambling is a sweet spot. Wynn understands that there are two things about China that cannot be broken. One is that a Chinese mother will never ever choose anyone over her only son. The second is that a Chinese person’s eyes gleam most brightly when they are gambling. Wynn Resorts provides international exposure to eye-gleaming high-rollers and it has a CEO that verbally flips off the American establishment for killing the dollar every time he gets on Bloomberg TV.

The Center: Commodities and the Carry Trade

It is natural to throw out the gold card here. No offense, but I refuse. Gold is a measure of financial system risk and uncertainty in general. But it is now a levered position on general uncertainty, so real chaos will screw it as a derisker. Also, general uncertainty eventually comes to focus on specific issues, and since it is expensive, there is no justification to buy up here. Now a declining dollar does make a case for commodities, but as the heightened sense of risk fades, commodities with more inelastic demand (demand that is relatively insensitive to price) are better.

Also, because emerging markets will develop and become increasingly financialized, these countries will have less organic demand for gold as a store of value. Their societies will become less cash/hoarding-based and more credit-centric. That is to say: if the “developed” world goes all mad max and we live off hard-tack and true little house on the prairie grit, China and the “emerging” world won’t use silver coins when they go to Applebee’s for Dim Sum.

Finally, it will take nothing short of a calamity to get to a gold standard. Any such calamity will delever the crap out of real assets like gold as people rush to dollars to settle their dollar debts. Also know that a gold standard takes all the economic adjustment pressure off the currency and on the labor and capital markets. Emerging societies that place a high premium on employment won’t like this at all. The gold standard may be stable in a local sense of currency stability, but it is very unstable in a broader social sense.

It is likely that the United States will have sustained low interest rates anchored to Fed policy compared to less demographically challenged countries (fewer old people getting assistance from taxes on the young). As a result, just like in Japan, the already massive carry trade will continue to spew out of the front end of the yield curve. It will grow like the Blob, enveloping everything and then collapsing everything in periodic return crashes. It is only natural that investors will want to get out of dollars and buy higher yielding local currency debt and equities. There will be shocks when people cash out when they need liquidity in dollars.

The Left Tail Hedge is Term Risk

If you want cheap exposure to shocks, buy vol. Since it probably the most mean-reverting of all things in the universe, it is reliably cheap only when it falls below its long term average. Even so, there is a carry cost to factor in. And be careful of the vol you buy. Those ETFs don’t give you the bang for the buck you may expect. See below. Normalizing the price action of VIX, a VIX ETN, and a VIX ETF show major tracking error exactly when VIX provides the most bang. This can lead to severe disappointment. VIX call spreads are well-understood way to cheapen this exposure.

Keep in mind that tail-risk killers won’t let the uncontrolled chaos manifested in volatility run around butt-naked for long. So a hedge needs to function not only for quick-reversing tail events but also for extended grinding dollar rallies that no type of volatility picks up very well. Pure term risk is the solution to capturing dollar rallies here. When I say “pure”, I mean minimize hybrid betas: combining credit risk with the term risk screws up the hedge.

So the natural exposure to term risk is long dated, dollar denominated bonds. In my experience, static hedges don’t work well. So you need bonds liquid enough to trade to make this hedge cost efficient. Buy when they are cheap within your system and sell when they are rich in your system. The coupon can fund volatility exposure or accumulate cash that can be reallocated to risk.

As credit risk increases with United States debt levels, protection could make the hedge too costly to keep. This credit risk will either force the hedge to become static, or the term risk component to be eliminated. Hedges based on systemic liquidity stress like TED spread widening are an alternative.

Sayonara

Guess what. If you believe what I am saying, then you believe we are pretty much following Japan. Almost everything I’ve said comes straight out of Japanese contemporary history. Our demographics are more favorable (better young tax-payer/old check-taker ratio). Our debt situation is different but still a disaster (less corporate debt; more household debt; government debt like a mushroom cloud just like Japan’s did in the nineties, naughties, and now). However, Japan’s debt is not external. Generally people and businesses are both creditors and debtors, so impairments to on one side benefit the other side. Also, when the declining dollar hits incomes sufficiently, there will be less need for Japan (and other marginal buyers) to manage its currency by buying Treasuries. They will look elsewhere for sales: emerging markets. But this will work itself out over slow as molasses.

The “exodus” theme I threw in is different from the Japanese experience, and this is no wonder. It is much less likely in recent history, but not rare either, for a Japanese family to uproot and become a stranger in a strange land. It was more common in the past. Japanese culture is more homogeneous, elders are respected because they lived responsibly over the years, and there is an implicit belief that, despite poor government and institutions, society as a whole will not permit egregious exploitation. The United States has none of these things. Instead, there is a fractured sense of community that exploits division and interlocking handouts from which everyone directly or indirectly benefits. It has baby boomers—arguably the most selfish, irresponsible jackasses the world has ever seen. And it has a government that has always been happy to kill its sons in wars for things even less tangible than a barrel of oil.

Negatively, but not immediately, as there have been no real recent developments. Implementation was accelerated during the last US credit crisis, but then slowed with the real estate crash in Dubai. Look for it to accelerate again when Bernanke & Geithner create the next US credit crisis.

You are whistling past the graveyard. It is a fiat currency collapse and it is already here. One day you will pull into the gas station and realize "interlocking stability of debtors and creditors" is bullshit. Debt is being repudiated daily, by home owners, by banks, and very soon by nations. The lesson of 2008 is interlocking instability.

Yo, smart guy. You think dollar destruction just started? It HAS been years and . . .even . . . decades.

And there really have only been a few reserve currencies in the history of the world. Guess what, the dollar occupies that position now because all the others failed!

Not a matter of if the dollar collapses, it's only when.

And, what you obviously fail to understand is that the Japanes benefit from the fact thattheir debt is held by their own people. As bad as it is over there, they don't have debtor nation status. They are a highly poductive society that can be said to have taken the LONG view of debt pay down to their own people. Good luck with us. We are loaded to the gills in personl and government debt (with a fair amount of corporate debt as well.) We have no savings rate to speak of and make very little. The dollar and military are our main exports. They are both poised for and historical epic crash.

We can discuss the particulars all day, but the similarities are striking, and with minimal personal saving, the no external debt issue, while true, looks stretched thin. One could argue that America is in better shape to replace marginal buyers with savers' money.

I'm not making comments as to what is desirable or right or fair. Just saying how I see it and could be worng just like the next guy.

Japan = high personal savings (which means the government could issue all that debt, even tho rates were kept arbitrarily low, so that they yen wouldn't appreciate too much & kill their exports & jobs).

US = very low personal savings rate which only picked up a couple of years ago once people figured out that house prices wouldn't skyrocket indefinitely.

And what is the rate of growth in government debt between the two countries (excluding the effect of the recent earthquake/tsunami natural disaster)?

The US was on the verge of hyperinflation back in the late 70s after Nixon took the dollar off the gold standard, despite being in a much more advantageous economic position than it is today.

It was only Volcker raising interest rates to loan shark levels that saved the $US back then - unfortunately we are heading for a repeat occurence on the $US, except this time the US is in a much weaker position economically relative to Europe, and emerging markets of China, India, Brazil, Russia, etc.

And I'd be a bit concerned about the middle east too, where the US government is up to its neck in supporting & upholding oppressive, failed regimes for decades so they could access cheap oil - I suspect the US will pay a price (perhaps higher oil priced in a new reserve currency) when those regimes are held to account by their people.

There will come a tipping point to the growing realization that the US monetary & fiscal policy is out of control, which even military superiority won't be able to hold back.

When it is reached, the collapse will be quick, complete and irreversible.

BTW I tend to get strident when it comes to the dollar's destruction. It is just so damn criminal. I think the article was well written but don't believe the comparison to Japan is apt (i've heard before.) Japan is essentially a nation of hard-working, homo geneous slaves who don't write down debt as a matter of personal honor. We don't RE-PAY debt as a matter of personal lifestyle. We will never vote for austerity as we are neither homogeneous (adhering to same values) nor hard-working.

Exporter nations aided by their financial facillitators have subsidized our excess to slowly drain our wealth creating machines over decades. Yes, those same decades during which the dollar has been systematically debased. Now, the parasite is leaving the host because the "blood" -- the strength of our economy in the form of a strong currency -- has been sucked dry.

"They would never let the dollar collapse because it hurts them just as much as us" you say? Well, look at where the world's productive resources reside -- most important among them a hard working populace. Then ask yourself "Why wouldn't they?"

(I also don't agree with our 'positive demographics'. Most of our "growth" comes in the form of recent arrivals to the US and their progeny. I have nothing against these folks and believe many are excellent additions. However, the strains on the system in the form of use of government resources that are not adequately replaced by tax revenue actually makes our systemic problems more acute.)

I understand about the dollar destruction. Asian countries have done it purposefully to stimluate export--i.e., work towards full employment. It's own turn now, and nothing is going to stop Ben. We need exports because there is nothing left in the US that hasn't been canabalized. This is the thinking at the Fed and White House.

A strong dollar makes labor markets weak. The debt binge was a fake way to supplement inxcome. it is unsustainable. Either way you look, we are all going to be a lot poorer when this is over.

I agree they can/will try. But one of the benefits of knowledge is time compression. Unfortunately, the interplay of time compression and knowledge in this case makes the effectiveness of "extend and pretend" policies less and less.

This has been well-documented on this site when it comes to state sponsored (allegedly) FX market operations. The half-life of these moves has reduced from months to weeks to days to minutes . . . and ultimately worsens the evntual collapse.

That's not true historically. You look at the mid nineteenth century to the end of the gold standard and you see the greatest amount of innovation in mankind's history. Real production, real tech advances, rapid spread of those and real growth, not just inflated GDP's. Gold standards give a fixed measuring point for trade and trading labor.

I can take a gold Panda, Maple Leaf, Eagle or plain ounce and trade it anywhere in the world. No one really cares what is printed on it. It will buy different amounts of labor and "stuff" in different parts of the world, but the measurement is at least the same, just like one foot equals one foot in the U.S. or China. You can change the measurement to meters but the measurements are still the same. No one gets cheated in these transactions.

The natural course of history and currencies with intrinsic value should be DEflation, not inflation. A dollar should buy more in the future, not less due to increased efficiency, productivity and innovation. Frankly, that's good for everyone when managed properly. However, our societies are all based on inflation which is good only for debtors and those who manage money. Governments are net borrowers and through the tax code give us incentives to become net borrowers.

Gold standards have their problems but they do not reduce innovation at all by any historical measures.

The rate of innovation compresses into the twenetieth century by number of patents or any other measure eclipses any other time period hands down. Period. This may be because most of the century was inh a state of perpetual conflict, I think not.

Low interest rates makes it easier to take long term risk and tech gambles. High interest rates puts the focus on short term gains with established cash flows. This is the benefit of paper money.

Well, I won't disagree with the interest rate statement. The flip side is simply the availability of money for risk. This should be priced into interest rates so that it is low when lots of money is available and high when short. However, venture capital perhaps at no interest but just a piece of the action comes into play, as well. Perot, Gates and Jobs were not heavily capitalized as they started.

My point is that the gold standard was not an impediment. I would argue that regulation, litigation and manipulation (of currency) are a bigger hindrance, now.

Paper also pays for wars and financed all those lovely twentieth century conflicts which were a waste of humanity and material.

This comment gave me something to think about. These are very good points, especially about the war and state can fund it by printing. The issue of low interest rates means that credit risk gets a sudsidy, and thiungs like junk bonds get bought.

I'm not sure in a godl standard poeple would part with their money in risky enterprises nearly as much, and this could slow innovation in things like fusion energy, or cancer cures, or whatever. This may be good or bad... I think bad.

No collapse? Nonsense. With enormous outstanding debt how can the currency slowly fall in value to half what it's worth today? If dollar holders get wind of the move they will rush to be the first to dump. This is like announcing to a theater audience that half the theater ceiling will cave in and expecting that half the people will remain seated. When Americans ffinally lose faith in their currency watch out below.

Using fiat (US military backed) dollars to buy goods from China and oil from the Arabs is a much easier way to get what we want for free without having to attack them. It's only when they won't accept fiat payment for their real goods, that we have to fire up the military machine.

Romans owned people. Whenever they ran into economic problems, they fought wars of subjugation to rob human resources and whipped their slaves harder. That artifically alleviated many of their currency problems as the world was younger and their were millions to enslave. Think a bank robber who robs one bank a year for $150,000 and supports his family with it. May work for the first several years, but sooner or later you run out of banks to rob/someone who doesn't like getting robbed stops you. When the gig is up, its up.

By the end, they f**ked things up so bad, they were begging/bribing barbarians to save them from babarians (and themselves.)

No collapse... weaker and weaker, devalued almost to nothing, but yet the dollar will ot collapse. The author has his reasons, but why take the long way round? I say no collapse because what other currency has a triangle on it that says "New World Order?"

It's the sexiest paper out there. Nothing else comes close! You can learn everything about alchemy and black magic from the Dollar Bill if you study it carefuly enough.

What you say is not impossible, but it is not likely in my view. Dollar weakness is a way to make the debt serviceable, and it is by design. It is default in miniscule particles instead of default as an all or nothing.

I also think your perspective is too domestic. Commodity inflation here may be bad, but it is worse elsewhere. Try China, Vietnam, actually anywhere else. Did you know that a Chinese company I know was fined for illegally hoarding US dollars?

Central banks know that a dollar collapse would be horrific to them, nbo one would benefit. So if needed, they'lll throw the swap lines in the other direction.

I think this is the same guy that regularly bashes boomers. By the way he personalizes his hatred for an amorphous demographic group, I figure he was sexually abused by a boomer and needs to vent his repressed pain through online screeds.

.... It's 'arguable' alright, because the boomers are the demographic that have paid the most into the big government Ponzi schemes whose existence predated them. They'll be the biggest losers of all time. The sounds coming from Washington DC these days are the sounds of the all the boomer promises and social contracts being broken -- after decades of the boomers paying into them.

The Gen Xers and Gen Yers don't have what it takes (or the numbers) to make good for their own generations. Their easy out is to rationalize killing off the boomers (Obamacare) and steal their property.... 'progress' these means that they're working on it.

You boomers need to stop smoking weed. I don't hate anybody. I see the source of our troubles--the corruption, the fraud, the creepiness that is Goldman as in the large a political failure to put a stop to it. You guys were in charge in terms of votes and leaders. Not only are not stopping the failures, but they started on your watch. Most boomers have saved little for retirement, stat speaking.

And yet it remains everyone's fault and problem but your own. You aren't the only people balming others of course. Just that you're going to eat the proverbial shit sandwich worse than anyone and most can't even see it at point blank range.

I'm a late boomer and while there are legit criticisms of that generation, realize it is an artifact. Most of the problems we have today stemmed from long before boomers. Fed in 1913, about 33 years before the first boomers. Socialism Security and the massive spread of Federal agencies, 1936, ten years before boomers. The Great Society programs and Medicare 1966. Boomers were not yet voting and were between 20 and 2 years old. Gold standard falls, 1971. Still a bit early for boomers. DE, EPA, etc, 1976. Now the boomers are just starting.

All the seeds for the crap that is happening now were planted long ago. Can you blame boomers for not fixing it? Well, yes, but no one has been up against this stuff before and guys the age of Pelosi and Reid (preboomers) defend this stuff tooth and nail.

Best put the blame where it belongs and frankly, I don't believe the generational thing much. It's more an evolutionary thing that developed over time and multiple generations. It will reach it's natural conclusion.

I agree, this isn't all about babay boomers. But when I hear all the blamestorming, I think of Japanese people that have lived in tents for months inKobe and Fukushima. We in contrast default as a convenience. It's breathtkaing and pathetic. How the rest of the world must look at us if they only saw through Zero Hedge.

While Zero Hedge is focus poitn of discontent, seems like the perception I gotten is that we Americans are weak, spoiled, and incredibly irresponsible.

So we have a duty to repay phoney bank debt that doesn't exist? I'd argue maybe, if we actully understood the nature of money before taking on the obligation. The collective obsfucation of the truth about banking means that banking has no claim on the repayment of its 'loans'.

As for naitional debt, the writing has been very clearly on the wall since 1971 at least. I just feel sorry for the japanese for not being able or willing to default a long time ago.

I've said this at least ten timee before and I'll say it again... it is not nothing. It is dollars you borrowed. If it is so meaningless, simply pay back these meaningless things you owe plus the interest you agreed on.

This is why I hate all these theoretical discussions of fractional reserve banking and the nature of money and such... it's not about understanding anything. It is about making excuses to be irresponsible.

IF there was understanding about what fractional reserve banking was than I would agree. Bank loans (not second stage earned money lending) absolutely does not exist, it is not dollars borrowed at all. It is an electronic sequence of binary code that the banking system agrees to exchange for dollars if people ask for it.

If a loan document had a clause that said 'The object of this loan is an electronic digit created by this bank via a computer entry and is deemed to be interchangeable for central bank money by this or other banks if requested (with notice)' THAN we would have transparency.

I ask you, if it is not about understanding anything and only about making excuses, why isn't it common knowledge? If you think the banks want this system understood i will eat my words.

My main problem is that there is a complete lack of undertanding on the issue, if people knew how banking worked (isn't withholding relevant information from a dependent party to a contract a means to void it?) than at least they could make an informed decision about their participation and support of that system. Hence I do not support the system simply because its structure and form is obfuscated.

Yeah sure, my point is also very simple: bank loans are non-functioning agreements and not repayable due to both no consideration and a material lack of disclosure, or even misrepresentation on the nature of the agreement (ie - representing the bank credit figure as a unit of actual currency).

My point stands - if you think banks want people to understand the lending process I'll eat my words.

Not that it detracts from your article, only that it is not dishonourable to not meet the terms of a materially misrepresented agreement (second-tier earned income loans excluded of course).

You are assuming the world would be a much worse place without lending but you cannot prove this, the proliferation of credit can accelerate development but it can also entangle and ensnare - just look at the great work produced by the world bank and the IMF in Africa, their most active area of operation.

Regardless, if a contract is a misrepresentation than it is fraudulent. I will not argue wether the world is better or worse without bank lending only that it is up to society to decide this and to do this society must first understand the lending process, which is obviously not the case at present.

So, if society cannot make an informed decision on bank lending because the truth about bank lending is obscured than it stands to reason that society's only defence against debt entrapment (default), is not morally reproachable in this case.

You make a good point but this is a sticky point for me. I say that the American people are better than the government we have, yet we reelect Frank, Pelosi and Reid. So, perhaps we get what we deserve.

I think we have systemic weakness in our government that breeds this irresponsible spending...no matter the party.

I think Americans are strong enough to get out of it, but they/we need clear leadership with the correct answers. That's the condundrum because virtually everyone in Congress has the wrong answers or solutions, Republican or Dem. The average guy doesn't really know who to pick.

In line with another poster here, I agree that we as citizens never agreed to or signed up for this debt that we are accumulating. It is identical to identity fraud. Someone has our name and bank accounts and is running up the tab without our express permission. I wish some idiot politician could present it that way. So, in a sense this debt is being run up without our permission and just like fraud, we do not owe it. I am not one for direct democracy but in matters of spending I could almost agree to it. How should someone else be able to saddle us with debt against our will?

Default is proper and the less traumatic of the ways to absolve our oversized debt. Hyperinflation would crush the economy and break down the economic ties and arrangements but its the chickensh*&%t way to do it. Therefore, that path will be chosen.